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Chapter 6: Risk and Risk Aversion
Chapter 6: Risk and Risk Aversion
1. a. The expected cash flow is: (0.5 × $70,000) + (0.5 × 200,000) = $135,000
With a risk premium of 8% over the risk-free rate of 6%, the required rate of
return is 14%. Therefore, the present value of the portfolio is:
$135,000/1.14 = $118,421
c. If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$135,000/1.18 = $114,407
d. For a given expected cash flow, portfolios that command greater risk premia
must sell at lower prices. The extra discount from expected value is a penalty
for risk.
2. When we specify utility by U = E(r) – 0.005Aσ 2 , the utility level for T-bills is 7%.
The utility level for the risky portfolio is: U = 12 – 0.005A × 182 = 12 – 1.62A
In order for the risky portfolio to be preferred to bills, the following inequality must
hold:
12 – 1.62A > 7 ⇒ A < 5/1.62 = 3.09
A must be less than 3.09 for the risky portfolio to be preferred to bills.
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3. Points on the curve are derived by solving for E(r) in the following equation:
U = 5 = E(r) – 0.005Aσ 2 = E(r) – 0.015σ 2
The values of E(r), given the values of σ 2 , are therefore:
σ σ2 E(r)
0% 0 5.000%
5% 25 5.375%
10% 100 6.500%
15% 225 8.375%
20% 400 11.000%
25% 625 14.375%
The bold line in the following graph (labeled Q3, for Question 3) depicts the
indifference curve.
E(r) U(Q4,A=4)
U(Q3,A=3)
5
U(Q5,A=0)
4
σ
U(Q6,A<0)
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σ σ2 E(r)
0% 0 4.000%
5% 25 4.500%
10% 100 6.000%
15% 225 8.500%
20% 400 12.000%
25% 625 16.500%
The indifference curve in Problem 4 differs from that in Problem 3 in both slope and
intercept. When A increases from 3 to 4, the increased risk aversion results in a greater
slope for the indifference curve since more expected return is needed in order to
compensate for additional σ. The lower level of utility assumed for Problem 4 (4%
rather than 5%) shifts the vertical intercept down by 1%.
5. The coefficient of risk aversion for a risk neutral investor is zero. Therefore, the
corresponding utility is equal to the portfolio’s expected return. The corresponding
indifference curve in the expected return-standard deviation plane is a horizontal
line, labeled Q5 in the graph above (see Problem 3).
6. A risk lover, rather than penalizing portfolio utility to account for risk, derives greater
utility as variance increases. This amounts to a negative coefficient of risk aversion.
The corresponding indifference curve is downward sloping in the graph above (see
Problem 3), and is labeled Q6.
8. d [When investors are risk neutral, then A = 0; the portfolio with the highest
utility is the one with the highest expected return.]
9. b
10. The portfolio expected return and variance are computed as follows:
rPortfolio
(1) (2) (3) (4) σPortfolio
(1)× (2)+(3)× (4 σ 2Portfolio
WBills rBills WIndex rIndex (3) × 20%
)
0.0 5% 1.0 13.5% 13.5% 20% 400
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0.2 5% 0.8 13.5% 11.8% 16% 256
0.4 5% 0.6 13.5% 10.1% 12% 144
0.6 5% 0.4 13.5% 8.4% 8% 64
0.8 5% 0.2 13.5% 6.7% 4% 16
1.0 5% 0.0 13.5% 5.0% 0% 0
11. Computing utility from U = E(r) – 0.005 × Aσ 2 = E(r) – 0.015σ 2 , we arrive at the
values in the column labeled U(A = 3) in the following table:
12. The column labeled U(A = 5) in the table above is computed from:
U = E(r) – 0.005 Aσ 2 = E(r) – 0.025σ 2
The more risk averse investors prefer the portfolio that is invested 40% in the
market index, rather than the 80% market weight preferred by investors with A = 3.
13. Sugarcane is now less useful as a hedge. The probability distribution is as follows:
Normal Year for Sugar Abnormal Year
Bullish Stock Bearish Stock
Market Market
Probability 0.5 0.3 0.2
Stock
Best Candy 25.0% 10.0% −25.0%
Sugarcane 10.0% −5.0% 20.0%
Humanex’s Portfolio 17.5% 2.5% −2.5%
Using the distribution of portfolio rate of return, the expected return and standard
deviation are calculated as follows:
E(r p) = (0.5 × 17.5) + (0.3 × 2.5) + [0.2 × (–2.5)] = 9.0%
σ p = [0.5 × (17.5 – 9) 2 + 0.3 × (2.5 – 9) 2 + [0.2 × (–2.5 – 9) 2] 1/2 = 8.67%
While the expected return has improved somewhat, the standard deviation is now
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significantly greater, and only marginally better than investing half of the portfolio
in T-bills.
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14. The expected return for Best Candy is 10.5% and the standard deviation is 18.9%.
The mean and standard deviation for Sugarcane are now:
E(r) = (0.5 × 10) + [0.3 × (–5)] + (0.2 × 20) = 7.5%
σ = [ 0.5 × (10 – 7.5) 2 – 0.3 × (–5 – 7.5) 2 + 0.2 × (20 – 7.5) 2] 1/2 = 9.01%
The covariance between Best Candy and Sugarcane is:
Cov(rBest , rCane ) =
[0.5(25 – 10.5)(10 – 7.5)] + [0.3(10 – 10.5)(–5 – 7.5)] + [0.2(–25 – 10.5)(20 –7.5)] = –68.75
15. Using the results from Problem 14, the portfolio expected rate of return is
computed as follows:
E(rp) = (0.5 × 10.5) + (0.5 × 7.5) = 9%
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